Just One ETF: Digging Out Premiums From Small-Cap Value Stocks

Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Steven Geri is founder of InvestSimply, an RIA and Web-based portfolio management service for individuals and families. Previously, he worked with the institutional division of Charles Schwab, and evaluated corporate mergers and acquisitions at the strategy consulting firm Booz Allen Hamilton.

Which single asset class are you most bullish/bearish about in the coming year? What ETF position would you choose to best capture that?

InvestSimply focuses on crafting long-term investment portfolios for clients with a time horizon beyond the next 12 months. As part of a well diversified portfolio, we feel domestic, small-company value stocks are a core holding with good prospects for total return investors. That being said, we employ a strategic asset allocation approach and don’t make tactical bets on single asset classes or sectors.

One facet of our investment philosophy is a belief in the risk premium (i.e., higher return) offered to investors in small companies and in value stocks. Within our strategic asset allocation, we overweight our equity allocation to small-company stocks and tilt our portfolios toward value stocks (relative to their respective market weights). These portfolio tilts result in an underweight to large-cap stocks and to growth stocks. Similarly, for developed international equities, we apply the same small-cap overweight and the same value tilt to our allocations.

An ETF we find well suited to helping achieve both exposure to domestic small company stocks and providing the desired value tilt is Vanguard’s Small-Cap Value ETF (NYSEARCA:VBR). Depending on how deep a value tilt you desire, this fund can be used in tandem with a small-cap blend fund to round out the portfolio’s domestic small-cap allocation.

How does VBR fit into your overall investment approach?

InvestSimply’s investment approach is rooted in Modern Portfolio Theory (MPT). We complement MPT with insights from the “endowment model” of investing popularized by David Swensen (who manages Yale University’s endowment) and from the Fama-French Three Factor Model. We craft broadly diversified portfolios across multiple asset classes with an emphasis on stocks over bonds, and tilt toward small-cap and value stocks. We use Treasury bonds to dampen volatility and provide protection during times of market stress. Furthermore, we populate portfolios with exposure to low-correlation alternative asset classes such as real estate, commodities and hedge-fund strategies.

We believe in the power of index-fund investing for capturing market rates of return. As index investors, we strive to keep investment expenses low, including fund expense ratios and trading expenses. Portfolios are structured based on a strategic asset allocation appropriate to the client’s situation. We don’t make tactical bets on specific sectors or asset classes, but aim to maintain the long-term asset allocation within tolerance bands through periodic rebalancing.

VBR is the quintessential fund to represent our investment approach. As a low-cost index fund, it provides equity exposure for a very low fee, while providing both the small company and value stock tilts we favor. That being said, we like this fund as one part of a diversified portfolio and not as a standalone bet.

Tell us a little more about small-cap value. What makes that area your top pick?

A number of studies have identified a return premium for investors in small value stocks. This historical relationship is captured in Fama and French’s Three Factor Model as well as in historical returns over the past 40 years. Using analysis from Morningstar (see below), small value stocks significantly outperformed growth and large-cap stocks in the United States.

Growth & Value Investing (1970-2010) – compound annual return

Small Value

15.00%

Large Value

10.50%

Small Growth

8.80%

Large Growth

7.60%

Source: Morningstar

Value outperforms growth and small outperforms large. By tilting a portfolio toward small value, investors can attempt to capture both of these historical return premiums.

Are there alternative ETFs that could be used to capture the same theme? What makes this specific ETF your first choice?

Several other funds also provide exposure to U.S. small-cap value stocks, including iShares Russell 2000 Value Index (NYSEARCA:IWN) and iShares S&P SmallCap 600 Value Index (NYSEARCA:IJS). These two funds track different indices, the Russell 2000 Index and the S&P Small Cap 600 Index respectively, whereas VBR tracks the MSCI U.S. Small Cap Value Index. Vanguard also has a couple of newer funds (launched in September 2010) tracking the same indices as the iShares funds; Vanguard Russell 2000 Value Index ETF (NASDAQ:VTWV) and Vanguard S&P Small-Cap 600 Value Index ETF (NYSEARCA:VIOV).

We prefer the Vanguard Small Cap Value ETF (VBR) for a number of reasons. First of all, Vanguard has the lowest-cost ETFs in this category with an expense ratio for VBR of only 0.23%. Together with the two iShares funds mentioned above, VBR has by far the largest asset base among ETFs tracking this category. Hence these funds should have the most liquidity and smallest bid/ask spread, further reducing the cost to own this fund.

Finally, the MSCI index that VBR tracks includes more mid-cap stocks than the other indices mentioned and therefore has a larger average market cap. This tilt toward mid-cap provides added exposure to mid-caps without the need to purchase a specific mid-cap fund (could work particularly well if paired with a large-cap fund also with a tilt toward mid-cap).

Over the past five years (as of April 30), VBR had an annualized return of 3.9%, outperforming both the Russell 2000 Value TR Index (at 2.5% annually) and the Morningstar Small Value category (at 2.1% annually). VBR’s current SEC Yield is 1.9%.

Does your view differ from the consensus sentiment in this area?

We generally believe a contrarian investment approach (vs. the consensus) offers the best opportunity for superior returns. Once an asset category becomes “hot,” you have probably missed the opportunity. By continually investing into out-of-favor asset categories (through systematic rebalancing), we hope to buy in low while selling out of highly appreciated asset categories.

Viewed with this contrarian lens, domestic small-cap value stocks look promising (i.e., the category appears to be out of favor by the consensus). Looking at “fund flow” data from Morningstar for ETFs, the Small Value category is out of favor by the consensus, experiencing net outflows both during Q1 2011 and over the 12 months ended March 31. Conversely, the Emerging Markets and Precious Metals categories appear to be favored by the consensus, experiencing the largest increase in ETF market share over the past year, although both also experienced outflows during Q1.

Most recently, based on Morningstar’s April ETF flows, Small Value was the only U.S. Equity style box to experience outflows. Total U.S. stock ETFs generated $10.2 billion of net positive flows during April, while the Small Value category bled $223 million. So at least in the very short term, small value is a good contrarian bet.

What catalysts, near-term or long-term, could move this segment of stocks significantly?

Clearly, since this index fund holds a large number of companies (nearly 1,000 names) in different industries, the overall growth of the U.S. economy and health of the equity markets will determine the investment's broad movement. Relative to other equity investments, small-cap stocks could benefit from an increase in mergers and acquisitions by larger firms.

What could go wrong with your pick?

Small-cap stocks are generally not as exposed to international markets as their large-cap brethren. If growth rates accelerate faster outside the U.S. than domestically, U.S. small-caps could underperform. Furthermore, value stocks could underperform growth stocks in a robust economic recovery.

By including VBR as one component of a well diversified investment portfolio, investors can guard against market conditions unfavorable to this single ETF pick. Although at InvestSimply we favor small-cap and value stocks, we still maintain exposure to the broad equity markets, both international and domestic, as well as a significant allocation to alternative asset classes.

This international-market issue is the interesting question for me, since I've seen advisers this past year talking about shifting from small-cap value to emerging markets, and vice versa. Isn't it about where your exact horizon is, since you can backtest various decades and small-cap/value tends to outperform broader indexes and long bonds?

Clearly the relative historical performance of different asset classes will vary depending on the time period you choose to look at. And although domestic small-cap value has outperformed other domestic equity historically, emerging markets have dominated over the past 10-plus years. Most data on individual investors shows a significant “home country bias” with equity allocations heavily weighted to domestic stocks relative to the U.S. share of global market capitalization.

At InvestSimply, we build portfolios with an international equity allocation of around 40-45% of the portfolio's overall equity allocation. Still underweighted on a global market cap basis, but far higher than most individual investors are accustomed to. Within the international allocation, we overweight emerging markets (relative to share of global market cap) for clients with a higher risk tolerance.

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